TWO CHEERS FOR LEGALISM: A Review Of Hernando De Soto's The Mystery Of Capital

In interviews given before he was confirmed as Treasury Secretary, Paul O'Neill repeatedly criticized the failure of organizations like the International Monetary Fund to foresee the recent meltdown of emerging markets. "Have you ever tried to do business in Russia?" O'Neill asked one reporter. "Ever tried to write an enforceable contract? . . . It doesn't take a genius to figure out it's not a great place to put capital."

Explaining precisely why the third world — and for present purposes, Russia counts — isn't "a great place to put capital" is the point of Hernando De Soto's excellent new book, The Mystery of Capital (Basic Books 2001).

The West is rich, and rarely questions capitalism's virtues. Most of the rest of the world is poor, and is today profoundly cynical about capitalism. The mistake seems obvious. What's wrong with these people? According to De Soto, the problem is that the third world has experimented with capitalism without the necessary tools for creating capital, an experiment doomed to failure.

The problem is not a lack of energy, or intelligence. It is not even a lack of resources: in Haiti, for example, the total value of the untitled land on which the poor are living is roughly $5 billion, four times the assets of all the legal businesses operating in Haiti. The problem, rather, is that the poor have no way of turning such untitled land into capital because they do not have legitimate and effective systems of property rights.

"Property," as every first year law student learns it, is a bundle of rights in a thing. When you say you own your house, for example, you're really saying you have a well-understood set of complex rights with respect to some land and some structures on it. The contours of the land on which your house is built are well defined on a map in the county surveyor's office. On this land, you have the right to build or destroy structures or natural features, and of course, you have the right to sell the land or encumber it with debt as much as you want (and as much as your mortgage lender will let you).

This bundle of rights, according to De Soto, is the crucial difference between the West and the rest of the world. A McMansion in Silicon Valley and a shack on the outskirts of Peru both provide shelter. But the McMansion provides more: in America, the most common form of seed money for a new business is a second mortgage on the entrepreneur's home. A western lender can easily identify what a homeowner owns, how much equity she has, and how large a loan that equity warrants. The house thus becomes "capital," as economists understand the term. It has value beyond the bricks and mortar, anchoring a variety of transactions that are the lifeblood of modern capitalism.

Such transactions are impossible for the owner of the shack. Even if a third world citizen can amass the necessary wealth, and can pay the necessary fees, he still has to navigate countless local and national bureaucracies before he can own his home. The legal purchase of a house takes about 90 days in this country; according to De Soto, it can take fourteen years in Egypt, nineteen in Haiti.

Under these circumstances, it is not surprising that few people from the third world own their own homes. As a direct consequence, they will never be in a position to turn their homes into sources of capital for any number of transactions, such as starting a business or financing a college education. The homes of the poor represent, according to De Soto, "dead capital": the lack of clear legal title means they cannot serve as anything more than shelter.

The problem with dead capital goes well beyond home ownership. De Soto has documented the extraordinary legal and bureaucratic barriers to starting legitimate businesses outside the West. In England, a business owner can pledge her inventory as collateral for a loan, which she can then reinvest in her business or some other venture. But what if a business is not properly licensed by the byzantine Phillipine bureaucracy, and the government could seize its inventory at any moment? No lender would accept such insecure assets as collateral. Here again, the difficulty of making legal economic arrangements in the third world prevents entry into the modern marketplace.

De Soto reminds us that the market we take for granted has only existed for two hundred years or so. The pre-Civil War American west was, in fact, remarkably like today's third world. Title to land was uncertain, and the man who settled a lot outside Chattanooga may well not have known that a Hartford bank held a deed to that same lot.

How that contest was settled is a fascinating chapter in American legal history. In 1821, the Supreme Court decided Green v. Biddle, which pitted a formal titleholder against a squatter on a Kentucky lot. The Court ruled in favor of the titleholder. But in the ensuing years, Biddle became one of the most universally ignored high court opinions ever rendered. Biddle was unworkable, because local communities recognized the legitimacy of squatters' claims, sometimes enforcing those claims at the point of a gun.

For the rest of the nineteenth century, local politicians put aside Biddle and the ancient deeds it sanctioned and rewrote land law, county by county, taking account of the realities and customs on the ground. Overwhelmingly, the squatters won those battles. But having mapped the land and assigned rights in it, the politicians promptly enshrined the formalism that is the hallmark of modern American property law. Green v. Biddle was the right decision at the wrong time: a formal system of property rights must be legitimate before it can be effective. Today, our system of property rights allows the extraordinary variety of real property transactions that are so important to American capitalism.

The lessons of this history are complex. The process of fixing American property rights required recognizing the interests of squatters — by definition, those who assert a less than legal interest in land. Similarly, property and business ownership throughout the third world is, according to De Soto, predominantly illegal. But it was only through the accommodation of such putatively illegal arrangements that the United States established an effective system of rights that today doesn't need to accommodate much illegality at all.

If a nation's legal system cannot accommodate the economic arrangements of the majority of its citizens, then, De Soto says, it is the legal system, not the economic arrangements, that must yield. De Soto knows first hand — he is one of the architects of Peruvian reform — that the process of integrating a nation's illegal activity into a legitimate framework will be long, painful, and strenuously opposed by entrenched elites. The alternative, however, is to banish five-sixths of the world's population from the blessings of market capitalism. Those blessings are now chiefly enjoyed by mostly western nations. But it is not western arrogance to say that much of the world is not ready for capitalism -- a mere 150 years ago, neither was the West.